CalSTRS Pension Shortfall

7/29/2019 CalSTRS Pension Shortfall

1/26

TEACHERS' RETIREMENT BOARD

REGULAR MEETING

______________________________________________________________________________

SUBJECT: SCR 105 Report on System Funding ITEM NUMBER: 6

CONSENT: ATTACHMENT(S): 1

ACTION: MEETING DATE: February 8, 2013 /2 hrs.

INFORMATION: X PRESENTER: Ed Derman

______________________________________________________________________________

PURPOSE

This item is provided to review the final draft of the report being submitted to the Legislaturepursuant to Senate Concurrent Resolution (Negrete McLeod) of 2012.

BACKGROUND

SCR 105 HQFRXUDJHV &DO6756 in consultation with affected stakeholders, including, but not

limited to, the Department of Finance and organizations representing members and schoolemployers, to develop at least three options to address the long-term funding needs of the

Defined Benefit Program in a manner that allocates any increased contributions among

members of the system, school employers, and the state, consistent with the contractual rights of

existing members, and submit those options to the Legislature before February 15, 2013

Staff has been meeting with stakeholders to develop parameters upon which alternative funding

options would be based, and discussed potential options with the stakeholders. In addition, at theJanuary 2013 meeting, the board discussed the structure of the report and the options being

presented in the report.

$WWDFKHG LV WKH ILQDO GUDIW RI WKH UHSRUW IRU WKH ERDUGV UHYLHZ SULRU WR LWV VXEPLVVLRQ WR WKH

Legislature.

75%
http://www.leginfo.ca.gov/pub/11-12/bill/sen/sb_0101-0150/scr_105_bill_20120910_chaptered.pdfhttp://www.leginfo.ca.gov/pub/11-12/bill/sen/sb_0101-0150/scr_105_bill_20120910_chaptered.pdfhttp://www.leginfo.ca.gov/pub/11-12/bill/sen/sb_0101-0150/scr_105_bill_20120910_chaptered.pdf


2/26

75%


3/26

Attachment 1Regular Meeting Item 6

February 8, 2013

1 of 25

EXECUTIVE SUMMARY

Since the market downturn in 2008, state legislatures around the country have been dealing with

the financial challenges facing their public employee retirement plans. The legislative responseshave addressed the benefits provided by the pension plans as well as the financing of those plans.Between 2010 and 2012, at least 27 states, besides California, enacted legislation increasingmember and/or employer contributions to their pension plans. Last year, the CaliforniaLegislature enacted Assembly Bill 340 (Furutani) to address the benefits provided by publicemployee retirement plans in California. In the legislative hearings that led to the passage of AB340, frequent reference was made by the California State Teachers Retirement System(CalSTRS) and others to the unfunded liability that CalSTRS was facing with respect to itsDefined Benefit (DB) Program.

In response to those discussions, Senate Concurrent Resolution 105 (Negrete McLeod) of 2012

encourages CalSTRS to work with affected stakeholders to develop at least three options toaddress the long term funding needs of the DB Program, and submit a report on those options byFebruary 15, 2013. The DB Program is the primary, and often the exclusive, source of ongoingguaranteed retirement income paid to a public educator in California. As of June 30, 2011, theliabilities of the DB Program exceeded the program assets by $64 billion, and if currenteconomic and demographic assumptions were to hold, the program would deplete all of its assetsby 2046. At that point, the state, as plan sponsor, would be responsible for ensuring that theconstitutionally-guaranteed benefits were paid. In 2011-12, benefit payments totaled $10.7billion.

The resources generated from contributions made by members, employers and the state are

projected to be more than sufficient to cover the ongoing costs of the DB Program (also knownas the normal cost); the shortfall was caused primarily by the weak financial markets since2000, and the shortfall has been exacerbated by those contributions not being adjusted earlier tooffset the investment losses. The benefits provided to current DB Program members are notexcessive, and AB 340 addressed the weakest aspects of the plan design. Although the changesenacted in that legislation will reduce the liabilities accrued as a result of service of futuremembers, those benefit changes are nowhere near sufficient to fully offset the funding shortfall.Any additional reductions to the benefits paid to members would have limited impact onprogram funding because the reductions could only apply to future members. In addition, thosereductions would likely significantly undermine the retirement security of those members, whodo not earn Social Security benefits for their public education service.

The most effective means to provide long-term stability to the DB Program is to increasecontributions made by members, employers and/or the state. Those contributions are fixed instatute; the CalSTRS board has no authority to establish the contribution rates. In addition, thoserates have been remarkably stable. Member rates have not been increased since 1972, employerrates have not changed since 1990, and the states rate is lower now than it was in 1997.

75%


4/26

2 of 24

To provide long-term financial stability will require a significant increase in contributions. Thereare six key decisions the Legislature and the Governor must make in order to address the fundingshortfall. They are:

1. What is the financial objective?2. Over what period of time that objective should be achieved?3. When should contributions rates begin to increase?4. How quickly should those contribution rates be increased?5. How should those contribution rate increases be allocated among current and future

members, employers and the state?

6. When should the Legislature and the Governor re-evaluate the DB Program fundingchanges being made?

The report identifies four alternative financial outcomes. In order of descending long-termimpact on the DB Program, they are:

1. Fully fund the DB Program2. Establish a target ratio of program assets to program liabilities3. Increase contributions to avoidfully depleting assets in the future4.

Increase contributions to delay the date assets are fully depleted

It is CalSTRS expectation that contribution increases would occur gradually over time, and likelynot be implemented for a period of time, in order to allow affected stakeholders to makeadjustments in their spending plans to accommodate the increases. A more rapid increase incontributions (for example, a one percentage point annual increase versus a percentage pointannual increase) has a greater positive impact on program funding than an earlier implementation(a 2014 implementation versus a 2016 implementation), if the increase in the contribution rate issignificant. If the total increases are relatively small, when those increases begin, rather than howquickly they increase, will be of greater significance.

The timing of the enactment of legislation to address the funding shortfall, regardless of whenthe legislated changes become effective, can significantly affect the financial statements ofschool districts. Accounting standards for public employers recently adopted by theGovernmental Accounting Standards Board will affect the financial statements of those schooldistrict employers if pension fund assets are expected to be exhausted in the future. If legislationis enacted in this legislative session that avoids an expected depletion of program assets in thefuture, future school district financial statements will not reflect pension liabilities based on

75%


5/26

3 of 24

excessively low expected rates of return. Requiring the disclosure of liabilities based on theselow expected rates of return could, for example, hinder the ability of school employers toimplement their financial programs to improve their infrastructure, by making it appear that theschool employers have higher levels of existing debt.

In addition, there is a very high likelihood, given the 75 years over which this report makesprojections and the probability that from year to year actual investment experience will varyfrom the assumed rate of return, that any increase in contributions will result in too little or toomuch money being generated for the DB Program during that time period, if no furtheradjustments to contribution rates are made in the future. As a result, the Legislature shouldanticipate that the contribution rate program enacted in the legislation needs to be re-evaluated inapproximately ten to 15 years, so any needed adjustments can be made.

CalSTRS stands ready to assist the Legislature and the Governor in projecting the implications ofalternative approaches requested and providing information desired to address this importantissue.

BACKGROUND ON THE DEFINED BENEFIT PROGRAM

The California State Teachers Retirement System (CalSTRS) administers a hybrid retirementsystem consisting of a traditional defined benefit component (the Defined Benefit, or DB,Program), a cash balance component (the Defined Benefit Supplement, or DBS, Program) and adefined contribution component (Pension2, a voluntary 403(b)/457 program). By far, the mostsignificant component of this hybrid system is the DB Program. The DB Program providesretirement, disability and survivor benefits to academic personnel in California public education(prekindergarten through grade 12 and community college), such as teachers and faculty,academic administrators, counselors, librarians, nurses and others who are required to hold acredential or meet appropriate minimum standards set by the Board of Governors of theCalifornia Community Colleges. Similar personnel who work in charter schools whose charterelects CalSTRS as their retirement administrator also participate in the DB Program. Membersof the DB Program do not earn Social Security benefits for their public education service.

Relatively Modest Benefits Paid to Current DB Program Members

The retirement benefit is based on the retiring members years of service, age at retirement andfinal compensation. The member generally must have at least five years of service credit toretire. For members who were first hired prior to 2013, the normal retirement age is age 60, andthe benefit paid at that age equals 2 percent of final compensation per year of service. (Bycomparison, many other current state and local non-safety employees can retire with a benefit of2 percent of final compensation per year of service as early as age 55.) This is known as theCalSTRS 2% at 60 formula. Members who retire after age 60 retire with a higher percentageof final compensation for each year of service. The maximum percentage of final compensationper year of service payable as a benefit is 2.4 percent at age 63. Members can retire as early asage 50 (if they have at least 30 years of service) or age 55 (if the member has less than 30 yearsof service) with a benefit that is based on a declining percentage of final compensation per yearof service as the retirement age drops.

75%


6/26

4 of 24

In addition, if the member retires with at least 30 years of service, the percentage of finalcompensation for each year of service upon which the retirement benefit is based is increased by0.2 percent (an enhancement referred to as the career factor), up to the maximum 2.4 percent,which would be reached at age 61. For example, a member retiring at age 60 with less than 30

years of service will receive a benefit equal to 2 percent of final compensation per year ofservice, while a member retiring at age 60 with 30 or more years of service will receive a benefitequal to 2.2 percent of final compensation per year of service. For members retiring with at least25 years of service, final compensation is based on the highest 12 consecutive months of theaverage annual full-time salary rate; otherwise, final compensation is generally based on thehighest average annual full-time salary rate for three consecutive school years. All benefits areincreased each year by an amount equal to 2 percent of the original benefit. The median benefitpaid to the members who retired in 2011-12 replaced 53 percent of their final compensation.

Future DB Program Members Will Have Lower Benefits

For members first hired in 2013 and thereafter, the DB Program retirement benefit is smallerthan that paid to CalSTRS 2% at 60 members. Although the benefit paid at normal retirementage remains 2 percent of final compensation for each year of service credit, the normalretirement age for these newer members is increased from age 60 to age 62. (This is referred toas the CalSTRS 2% at 62 formula.) As a result, the initial benefit paid to a CalSTRS 2% at 60member at age 60 will be paid to a CalSTRS 2% at 62 member with the same amount of serviceand final compensation at age 62, and the age that the maximum percentage of finalcompensation is paid will increase from age 63 to age 65. In fact, the percentage of finalcompensation per year of service paid to a CalSTRS 2% at 62 member generally will be thesame as is paid to a CalSTRS 2% at 60 member who retired two years earlier. CalSTRS 2% at 62members will not have their benefit enhanced by the career factor. Finally, the amount ofcompensation that will count towards retirement for CalSTRS 2% at 62 is limited to $136,440 in2013, an amount that will be adjusted each year for changes in the California Consumer PriceIndex.

The minimum required service credit remains at five years, but the minimum retirement age isage 55, regardless of how many years of service above five years the member was credited. Finalcompensation will be based on the highest three consecutive school years, regardless of thenumber of years of service earned. The 2 percent annual benefit adjustment will continue to bepaid. This lower benefit formula will reduce the median percentage of final compensation paid asa benefit from the current formulas 53 percent to about 47 percent, assuming the futuremembers age and service at retirement is the same as for recent retired members. This is verysimilar to what a private-sector employee with a similar amount of service would receive from atypical private-sector employer defined benefit plan, when combined with the Social Securitybenefits the employee would receive.

75%


7/26

5 of 24

CURRENT FINANCIAL STATUS OF THE DEFINED BENEFIT PROGRAM

The DB Program is financed from four sources. The first three sources are the members,employers and the state, which each pay contributions at a rate that is determined by statute; the

Teachers Retirement Board has no authority to set contribution rates. Only the contributionsfrom earnings attributable to a maximum of one year of service credit per school year arecredited to the DB Program; contributions from earnings attributable to service in excess of ayear per school year generally are credited to the members DBS account. CalSTRS 2% at 60members contribute 8 percent of their earnings (this DB Program contribution rate is equal to 44percent of the ongoing (or normal) cost of the DB Program benefit as of June 30, 2011).CalSTRS 2% at 62 members will contribute 50 percent of the normal cost of their benefitprogram, which currently results in a member contribution rate of 8 percent of earnings.Employers contribute 8.25 percent of the members earnings.

The states contribution rate is currently equal to 2.791 percent of the members compensation

earned two years ago for up to a year of service; the state makes no contributions forcompensation from service in excess of a year. The state contribution rate will be increasing by percentage point per year through 2015-16, when the states contribution rate reaches 3.522percent. (The state also makes a contribution of approximately 2.5 percent of the memberscompensation from two years ago to finance a program that protects the purchasing power of themembers DB Program benefit.) The final source of funding for the DB Program is theinvestment of these contributions. From 1984-85 through 2011-12, investment earningsrepresented about 58 percent of total resources available to fund benefits.

As of June 30, 2011, the normal cost of benefits of the DB Program was equal to 18.299 percentof covered earnings. With an effective total contribution rate of 19.418 percent, the contributionspaid by members, employers and the state, together with the investment of those contributions,are more than sufficient to pay the normal cost of benefits accrued in the DB Program, if allactuarial assumptions are met. However, because investment returns during the ten years endingin 2011-12 were 6.5 percent, which is below the assumed return on investments (currently 7.5percent, which is a reduction from the 8 percent return the Teachers Retirement Board hadassumed between 1995 and 2010), the actuarial value of liabilities of the DB Program associatedwith service already performed by members was $64 billion greater than the actuarial value ofassets. Put another way, the actuarial value of assets was sufficient to fund 69 percent of theactuarial value of liabilities at that time. Attached is a summary of the current status of the DBProgram provided by Milliman, CalSTRS independent actuary.

Based on the current law specifying the contributions paid by members, employers and the state,and assuming that investment returns and other economic and demographic assumptions arerealized, as of June 30, 2011, there were sufficient assets to fund benefits through 2046. Thebenefits owed to members and beneficiaries, however, are contractually guaranteed. Oneexception to this is an annual adjustment to benefits paid to members and beneficiaries. This isdiscussed in more detail on page 10. As a result, the state, as the plan sponsor, would have alegal obligation to ensure that benefits continue to be paid even after the DB Program assets aredepleted. It is currently estimated that the cost of paying benefits on a pay-as-you-go basis would

75%


8/26

6 of 24

be approximately 50 percent of covered earnings, because CalSTRS would have no opportunityto invest assets to help fund the cost of benefits.

The enactment of Assembly Bill 340 (Furutani) in 2012, also known as the California PublicEmployees Pension Reform Act, or PEPRA, will only slightly improve the financial status of

the DB Program. Rather than the DB Program depleting its resources in 2046, as was projectedin the June 30, 2011, actuarial valuation, the reduction in benefits accrued by CalSTRS 2% at 62members under AB 340 will reduce the normal costs of the program for those members by 2.61percent of earnings, and delay the projected date at which DB Program assets are depleted byone year, to 2047. This slight improvement in the viability of the DB Program, however, will bemore than offset by the impact on DB Program funding of the 1.8 percent investment return in2011-12, reflecting the ongoing weakness in the financial markets.

Other aspects of AB 340, however, such as the limitation on compensation upon which the finalcompensation of CalSTRS 2% at 62 members is determined, will have a beneficial impact onprogram funding, by substantially reducing the opportunity for members to spike their

retirement with large end-of-career compensation increases. Nonetheless, the magnitude of theimpact on the program funding for these additional spiking controls will be relatively smallbecause comparatively few members currently have such an opportunity to spike their benefit.

As stated above, the principal cause of the $64 billion unfunded liability is the weak financialmarkets since 2000. (Over the past 20 years, however, investment returns met the current 7.5percent annual investment return assumption.) If investment returns had equaled the currentlyassumed rate of return of 7.5 percent since 2000, the DB Program would have had sufficientassets as of June 30, 2011 to fund 103 percent of its liabilities. Moreover, the magnitude of theshortfall has increased throughout the decade because the amount contributed by the state and theemployer was a decreasing percentage of the amount needed to maintain full funding of theprogram. In 2001-02, when the DB Program first became underfunded, the state and employercontributed 90 percent of the amount needed to fully fund the program within 30 years. By 2011-12, that percentage had declined to 46 percent.

The Teachers Retirement Board first explored options to address the unfunded liability in 2004,following adoption of the June 30, 2003, actuarial valuation, which determined: that there was a$23.1 billion unfunded liability; the actuarial value of assets represented 82 percent of programliabilities; and the future contributions and investment returns were projected to be insufficient toamortize the unfunded liability over any time period. Since that time, the board has regularlycommunicated with the Legislature the increasing size of the funding shortfall, in transmittingboth the annual actuarial valuation of the DB Program, and CalSTRS annual financial report.During that time, CalSTRS has also continually communicated with stakeholder groups on thefunding shortfall, and facilitated their understanding on the need to increase contributions toaddress the funding shortfall.

HISTORY OF DB PROGRAM FUNDING

The funding of the DB Program has changed substantially in the 100 years since CalSTRS wasestablished in 1913. This is summarized in the timeline shown on the next page.

75%


9/26

1935 1944 1956 1959 1962 1972 1975 1979 1980 1981 1985 1990

Contribution Rate History

19501955

2 per year

ne

ercent of inheritancex revenue

$24 per year

$12 per year per employee

No change

1935

Member Contributions

mployer Contributions

tate Contributions

2.53 to 4.85 percent,

depending on gender

and age

No change

Pay-as-you-go

1944

5.77 to 10.15 percent

No change

No change

1950-1955


$12 per year plus up to

3 percent of salary

No change

1959


No change

No change

1959


No change

No change

No change

No change

$144.3 million per year

1972

1975

8 percent

3.2 percent, increasing to

8 percent by 197879

$135 million per year

1962

No change

No change

$144.3 million, increased

annually for ination, plus

$10 million, increasing to

$260 million by 1994-95,

increased for ination

1979

1980

No change

No change

Additional .307 percent

for ad-hoc benet

1981

No change

No change

Additional .108 through

1996 for ad-hoc benet

1985

No change

No change

Additional .25 percent for

unused sick leave

No change

Additional .25 p

unused sick leav

transferred to e

responsibility

4.3 percent, dec

percent annu

increments whefunded

1990

1998

No change

No change

3.102 percent

1.505 percent

benets unde

2000

No change

No change

2.585 percent

and 1.975 pe

beginning in 2

increasing to 2

percent of an o

in 2003-04

1/2

7 of 24

75%


10/26

8 of 24

In 1913, what is now the DB Program had only two sources of contributionsa $12 per yearcontribution from members and a state contribution equal to five percent of the revenuegenerated by the states inheritance tax. The employer did not make a contribution until 1935,when it began to make a $12 per year contribution. The members contribution increased to $24per year at the same time. Members who were first hired in 1935 or afterward contributed a total

of 4 percent of salary, of which only the first $24 was credited to the monthly benefit, with thebalance credited to the member's annuity account, similar to the current DBS account.

The next significant change in program funding occurred nine years later in 1944, when themembers contribution changed from a flat dollar amount to a percentage of compensation thatdepended on the age and gender of the member. In addition, the states contribution changedfrom a percentage of inheritance tax revenue to a pay-as-you-go payment, in which the state paidthe difference between the resources available and the cost of benefits in a given year.

The contribution rate charged to members, still based on the members age and gender, variedfor 28 years, from 1944 until 1972, when it became a flat 8 percent for all members. The

payment made by the state also changed in 1972, when it changed from a pay-as-you-gocontribution to a flat dollar amount of $135 million. This flat dollar amount was modified a fewtimes throughout the 1970s, until it reached about $400 million by 1990, and increased eachyear thereafter. Additional state contributions, based on a percentage of pay, were enacted in the1980s to fund specific benefit enhancements. The employer contribution was changed in 1972to a flat 3.2 percent of earnings, and that contribution rate increased gradually over the balance ofthe decade, until it reached 8 percent in 1978-79.

The next significant change in program funding occurred 12 years later, in 1990. The employerscontribution was increased from 8 percent to 8.25 percent, when the financial responsibility forfunding the conversion of unused sick leave to service credit at retirement was shifted from thestate to the employer. In addition, the flat dollar contribution by the state was replaced with acontribution rate equal to 4.3 percent of the members compensation, in addition to the othercontributions levied for previously authorized benefit enhancements, for a total of 4.607 percentin 1997. The 4.3 percent contribution would gradually be eliminated if and when the DBProgram became fully funded, which at the time was anticipated to be in 40 years. As a result ofthe superior investment returns in the 1990s, however, the DB Program became fully funded in1998. In 1998 and in 2000, the states contribution was reduced but made permanent inlegislation that also provided additional benefit enhancements to members, most of which willnot apply to CalSTRS 2% at 62 members, and which were primarily intended to encourageeducators to continue to work rather than retire. The 1998 legislation also provided for a limitedincrease in the states contribution if there was a normal cost deficit or unfunded liabilityassociated with the benefit program in place on July 1, 1990. Because there currently is anunfunded liability associated with the July 1, 1990, benefit program, the states contribution hasbeen increasing annually, and will continue to do so under current law, until it reaches itsmaximum statutory rate of 3.522 percent in 2015-16. For the ten years beginning in 2001, themembers contribution to the DB Program was reduced to 6 percent, with the remaining 2percent of compensation the member contributed to CalSTRS credited to the members DBSProgram account. In 2011, the members contribution to the DB Program was returned to theprior rate of 8 percent.

75%


11/26

9 of 24

MEANS TO IMPROVE DB PROGRAM FUNDING

There are three ways to improve the funding of the DB Program. The first approach is toimprove the return from investing program assets. The board regularly evaluates the allocation of

program assets to maximize its return on investment while maintaining an appropriate level ofrisk. Although the board could increase its allocation of assets in a manner that would beexpected to provide higher returns in the long-run, doing so would expose the investmentportfolio to even greater volatility and risk. In addition, although the DB Program has, in thepast, earned investment returns that enabled it to eliminate an unfunded liability much soonerthan expected, based on the June 30, 2011, actuarial valuation, as adjusted for the impact of AB340 and the 2011-12 investment return, it would require five consecutive years of over 17percent annual returns, followed by 25 years of meeting the assumed investment return of 7.5percent annually, to become fully funded in 30 years, or almost 10 percent annual returns for 30years to achieve full funding. Given the current allocation of program assets, there is about a 15percent chance that such returns could be realized in the future.

The second approach is to reduce program liabilities by reducing benefits. As mentioned before,the benefits provided by a public retirement plan, such as the DB Program, are contractualobligations, and California Supreme Court decision, effectively prohibit a reduction in theaccrual of future benefits for existing members. Generally, DB Program benefits only can bereduced for future members, as occurred in AB 340. Moreover, as discussed earlier, the financialchallenges facing the DB Program were not caused by the benefit structure, but by theextraordinarily weak financial markets since 2000. The revenues generated from contributionsmade by members, employers and the state are more than adequate to cover the normal costs ofboth the current and the new benefit formula, if actuarial assumptions are met.

In addition, AB 340 addressed the weakest aspects of the plan design, by further reducingopportunities for future members to enhance their benefits in an inadequately funded mannerthrough late-career compensation increases. Finally, the impact of such additional reductions inbenefits would likely significantly undermine the retirement security of affected members. Forexample, assuming there is no significant change in when future members retire, the benefit, as apercentage of final compensation, that the average retiring member will receive under CalSTRS2% at 62 formula is likely to be under 50 percent, and, because DB Program members do notparticipate in Social Security, this would represent the only ongoing source of retirement incomefrom their public education service. As discussed earlier, the benefits that will be paid to futuremembers are comparable to the benefits paid to those receiving typical corporate pension planbenefits, when the latters Social Security benefits are included. Any significant further reductionin benefits paid to future CalSTRS members would likely reduce the financial security of thosefuture members to a level below retiring private sector employees.

One idea that has been suggested to reduce DB Program liabilities for future members is torequire they participate in Social Security for their public education service, and reduce thebenefits paid under the DB Program. The CalSTRS independent actuary analyzed the cost ofmandating future members into Social Security. Their analysis indicated that including DBProgram members into Social Security would require either (1) a substantial total increase in

75%


12/26

10 of 24

costs incurred by affected members and their employers to pay the Social Security payroll tax,even after considering the reduction in their CalSTRS-related costs, or (2) further undermine themembers overall retirement security by reducing DB Program benefits in order to reduce DBProgram contributions to offset the cost of the Social Security payroll tax. In other words, thecost of providing benefits to California public educators exclusively through the DB Program is

less than it would cost to provide those same benefits from a combination of a reduced DBProgram and Social Security. This is primarily because CalSTRS reduces its program costs bypre-funding its benefits, that is, investing contributions received while the member is working, anattribute that does not exist in Social Security.

The final approach is to increase contributions. As stated before, contribution rates are set instatute, not by the Teachers Retirement Board, and, as the above history of those rates indicates,have been extraordinary stable, with the member and employer contribution rate not having beenincreased since 1972 and 1990, respectively, and the states contribution rate being lower than itwas in 1997. Moreover, the percentage of compensation that is contributed toward the retirementof a DB Program member in 2012-13 is considerably below the amount contributed toward the

retirement of California school or state employees covered by CalPERS, when the paymentsmade towards Social Security are included, as indicated in the following table.

Employee

Defined

Benefit

Employee

Social

Security

Employer

Defined

Benefit

Employer

Social

Security

State Totals

CalSTRS 8.00% N/A 8.25% N/A 5.29% 21.54%

CalPERS

School

7.00% 6.20% 11.42% 6.20% N/A 30.82%

CalPERS

State Misc.

8.00% 6.20% 19.65% 6.20% N/A 40.05%

As previously noted, since 2003, when CalSTRS first started discussing the need to address thefunding shortfall, CalSTRS has worked to educate stakeholder groups on the need to increasecontributions to address the shortfall. As a result, organizations representing CalSTRS membershave expressed a willingness to increase the contribution rate imposed on all affected parties,including members.

ADDRESSING THE DB PROGRAM SHORTFALL

Senate Concurrent Resolution 105 (Negrete McLeod), adopted in 2012, encourages CalSTRS,in consultation with affected stakeholders, including, but not limited to, the Department of Finance

and organizations representing members and school employers, to develop at least three optionsto address the long-term funding needs of the Defined Benefit Program in a manner thatallocates any increased contributions among members of the system, school employers, and thestate, consistent with the contractual rights of existing members, and submit those options to theLegislature before February 15, 2013. CalSTRS has been meeting with stakeholders to identifya variety of approaches that could be taken by the Legislature and the Governor to address thefunding of the shortfall.

75%


13/26

11 of 24

In developing the options for inclusion in this report, CalSTRS identified six primary issues thatthe Legislature and the Governor need to consider in developing a funding program. Theprimary issues are:

1. What is the financial objective?2. Over what period of time that objective should be achieved?3. When should contributions rates begin to increase?4. How quickly should those contribution rates be increased?5. How should those contribution rate increases be allocated among current and future

members, employers and the state?

6. When should the Legislature and the Governor re-evaluate the DB Program fundingchanges being made?

1. Define the Financial ObjectiveThe first issue that must be decided is the financial objective that the Legislature and theGovernor desire to achieve. CalSTRS has identified four alternative objectives, and, for purposesof responding to SCR 105, CalSTRS considers these alternatives to represent the options that theLegislature encouraged CalSTRS to develop.

x Fully fund the DB Program. Both accounting standards and fiduciary responsibilitywould dictate that the program be fully funded; that is, to have sufficient assets on handat a specific time to pay all liabilities that have accrued as of that date. (As of June 30,2011, the actuarial value of assets was sufficient to fund 69 percent of the programliabilities.) Having sufficient funds on hand in the program minimizes the long-term costof the program because CalSTRS can invest those funds to generate assets to payliabilities that would otherwise have to be funded from increased contributions.

The increase required to fully fund the program, however, would be significant. Ifimplemented on July 1, 2014, the total contribution rate from all sources would have toincrease by the equivalent of a projected 15.1 percent of compensation to fully fund theprogram in 30 years. Such a change would require a projected increased initial total

annual contribution at that time of about $4.5 billion from all combined sources.

x Establish a funding target. An alternative objective is to achieve a specific funded ratio.Under this objective, the contribution rate is set such that a specific targeted funded ratiois projected to be reached by a specified date. It is often cited that a pension fund that is atleast 70 or 80 percent funded is fiscally healthy. Under the federal Pension Protection Actof 2006, large private sector pension plans are considered at risk of defaulting on theirliabilities if they have less than 80 percent funded ratios under standard actuarial

75%


14/26

12 of 24

assumptions and less than 70 percent funded ratios under certain additional worst-caseactuarial assumptions.

Although useful as a general benchmark, the level of funding is less relevant indetermining the long-term viability of a pension fund than the direction in which that

funding level is headed. For example, a pension program that is currently 85 percentfunded, but which, given current contribution rates, liability accruals, and economic anddemographic expectations, is projected to experience continuing declines in that fundinglevel is, in fact, in worse shape, in the long-run, than a plan that is currently 50 percentfunded, but given those same considerations, is projected to be heading toward fullfunding.

Nonetheless, program financing could be set to target a specified funding level for aspecified future date. In this specific situation, given the current trajectory of the DBProgram funded ratio towards zero percent, establishing a reasonably high target wouldin fact substantially improve the financial viability of the program. If implemented as of

July 1, 2014, the total contribution rate from all combined sources would have to increaseby the equivalent of a projected 12.1 percent of compensation to fund 80 percent ofprogram liabilities in 30 years. Such a change would require an increased projected initialtotal annual contribution at that time of about $3.6 billion from all combined sources.

x Increase contributions to avoid full depletion of assets. Although full funding of the DBProgram is the optimal goal, it isnt necessary to achieve that level of funding in order forthe program to have long-term financial viability. A third, more modest outcome wouldbe to set contribution rates such that, given actuarial assumptions, there will always beprojected to be sufficient assets in the fund to pay benefits that are payable in that year,even if the DB Program never becomes fully funded. Because this objective is more

modest than full funding, the cost of avoiding a depletion of assets requires lowerincreases in contributions. If increased as of July 1, 2014, the total contribution rate fromall combined sources would have to increase by the equivalent of a projected 9.5 percentof compensation to avoid depleting the program assets. Such an increase would require aprojected total increased initial annual contribution at that time of about $2.9 billion fromall combined sources.

x Increase contributions to delay full depletion of assets. Finally, contribution rates couldbe increased to delay when the DB Program fully depletes its assets. This outcomerequires the smallest short-term increases in contribution rates, but also accomplishes theleast in addressing the long-term funding needs of the DB Program. As a result, it is the

least desirable, and ultimately the most expensive alternative identified. Under thisoutcome, the DB Program would ultimately deplete its assets, given its actuarialassumptions, but that depletion would be delayed for a period of time. A five percentagepoint increase in the contribution rate beginning in 2014 would, for example, delay theprojected date in which program assets were depleted to 2058. The projected initialannual cost of such an increase would be $1.5 billion. Such an approach would notsolve the problem; the Legislature would almost certainly have to make further changesat a future date to provide long-term viability to the program.

75%


15/26

13 of 24

2. Determine the Period of Time to Achieve ObjectiveThe required contribution rate increases cited above assume that, where applicable, the financialobjective is achieved within 30 years, a time frame that is consistent with governmental pension

accounting standards. In addition, the faster the objective is achieved, the less it costs to achievethat objective in the long run, because CalSTRS has assets to invest earlier.

There is no legal requirement, however, that an objective be achieved within any specifictimeframe. Lengthening the number of years available to achieve the objective will reduce therequired increased contribution, because the unfunded liability is being paid off over more years.This is analogous to a home mortgage. A homeowner with a 30 year mortgage will have lowerindividual mortgage payments than a second homeowner with a 15 year mortgage, because thefirst homeowner is paying off the mortgage over twice as long a period of time, and less of themortgage principal is being paid off in any single payment. However, because interest continuesto accrue on the mortgage, the first homeowner will end up paying more in total than the second

homeowner.

Extending the period of time that a specific objective in funding the DB Program is achievedwould have a similar impact. Fully funding the DB Program over 30 years, beginning in 2014,requires a projected increased contribution rate of 15.1 percent, whereas a 75 year amortizationperiod only requires a projected increased contribution rate of about 9.7 percent, and theprojected initial annual cost would be reduced from $4.5 billion to $2.9 billion, a reduction of$1.6 billion. In the first instance, however, a projected total of $121 billion (adjusted forinflation) in increased contributions would be paid, while the longer amortization period, eventhough the annual payment is less, would require a projected total payment of $254 billion.Similarly, achieving an 80 percent funded ratio in 30 years would require a projected increase incontribution rates of 12.1 percent, beginning in 2014. Reaching that level over 75 years wouldreduce the required projected increase in the contribution rate to 9.3 percent, reducing theprojected initial annual cost by $864 million, although the total projected increased contributionswould increase from $97 billion to $243 billion.

There is, however, a risk associated with substantially lengthening the period of time the shortfallis addressed because if investment markets underperform the assumptions, the funding shortfallbecomes more difficult to address. On the other hand, any increase in program resourcesimproves the funding situation as compared to current law.

3. Determine When Contribution Rate Increases BeginA third issue is when contribution rates begin to increase. As indicated earlier, fully funding theDB Program over 30 years beginning in 2014 would require a projected contribution rateincrease of 15.1 percentage points. The projected fiscal year 2014-15 cost of that increase wouldbe $4.5 billion. If legislation was enacted in 2013 to impose such a contribution rate, the partiesresponsible for paying that increase would have less than a year to accommodate that increase intheir spending plans. Each one percentage point increase in contributions paid by employers in2014 is projected to increase their costs by $300 million, while a similar increase in the state

75%


16/26

14 of 24

contribution rate would cost the General Fund about $279 million. A one percentage pointincrease in the members contribution rate would cost the average member about $700 per year.

Just as the period of time over which an objective is achieved can be extended, theimplementation of a contribution rate can be deferred. This would allow time for adjustments to

be made to spending plans to accommodate the increased cost. Because the unfunded liabilitywould continue to increase as implementation of a contribution rate increase is deferred, thecontribution rate required to achieve that objective also would increase. As a result, a trade-off isbeing created between short-term avoidance of increased costs and long-term increased costs.For example, delaying an increased contribution to fully fund the program in 30 years from 2014until 2016 would increase the projected required contribution rate increase by about onepercentage point. There would be a similar projected impact of a two-year delay in a program toincrease the funded ratio to 80 percent in 30 years.

4. Establish the Speed of Contribution Rate IncreasesThe estimates above are based on contribution rates being increased all at one time. Just as animmediate increase in contributions would strain the budget, so too would increasing thecontribution rates to the new level in one step. It has always been CalSTRS expectation that anyincreases in contribution rates would be gradual, in order to allow absorption of those increasesin spending plans. A gradual increase in contribution rates, however, has the same type of impactas a deferred implementation of the increase. Although the increased cost per year will be less ifthe increases occur gradually, the total cost will be higher, as will the total increased contributionrate required to achieve an objective. For example, fully funding the DB Program in 30 yearsrequires an increased projected contribution rate of 15.1 percentage points. Imposing thatincreased contribution rate in three percentage point annual increments requires the contributionrate to increase by a projected total of 17.2 percentage points. Increasing the funded ratio to 80percent in 30 years requires a projected 12.1 percentage point increase in contributions;increasing the contribution rates in three percentage point annual increments would increase thetotal required projected increase to 13.3 percentage points. Although the increased costs ofachieving either objective would occur more gradually over time if the increases areimplemented incrementally, the ultimate cost of achieving either objective would be higher ifcontribution rates are increased incrementally.

Between the timing of the contribution rate increase and the number of years over which thatincrease takes place, the rate of speed of the increase in contribution rates can have a moresubstantial impact on the effectiveness of a contribution rate increase than would thecommencement of the increase, if the contribution rates are increased significantly. For example,if the total contribution rate from all combined sources were to increase by the equivalent of 15.1percent of earnings in 2014, the DB Program is projected to be fully funded in 2044. If thatincrease were delayed by two years until 2016, the projected funded ratio in 2044 would bereduced to about 89 percent, and the full funding of the program is projected to be delayed byfive years, until 2049. On the other hand, if total contributions were increased by one percentagepoint each year beginning in 2014, until the total rate had increased by a total of 15 percentagepoints, the projected funded ratio in 2050 would be 73 percent. If the contribution rate increasedby the same 15 percentage points, in increments of only percentage points each year beginning

75%


17/26

15 of 24

in 2014, the projected 2050 funded ratio would be 41 percent, and a percentage point annualincrease in the contribution rate would result in a projected 2050 funded ratio of 7 percent. If,however, the total contribution rate increase is relatively small, the timing of when thoseincreases begin is more significant than how quickly they increase.

There is, in addition, a limit on how small the annual increment in the contribution rate can beand still have a meaningful impact on funding the DB Program. The smaller the annual increase,the less time that CalSTRS has to invest the additional funds, and the larger the total increase inthe contribution rate would need to be to achieve a particular objective. Moreover, there may notbe sufficient number of years for the contribution rate to reach its ultimate total. For example, ifthe annual increase in the contribution rate imposed were to be limited to percent annually for30 years, the rate would only be able increase by 7.5 percentage points, to 15.75 percent, and theDB Program would be projected to deplete its assets in 2053. If the annual increment were percentage point, increased contributions would be invested sooner, and the total contributioncould increase by 15 percentage points within the same period of time. Under that approach, DBProgram would be projected to be 53 percent funded in 75 years.

Although a moderately delayed implementation of a program to address the funding shortfallmay have a more limited impact on the effectiveness of the program, an earlier enactment of theprogram through legislation, even with delayed implementation, could materially affect thefinances of school employers. The Governmental Accounting Standards Board (GASB) is anindependent organization that sets accounting and financial reporting standards for state andlocal governments. Under recently approved GASB standards, public employers who areresponsible for funding pension liabilities are required to disclose those liabilities within theirfinancial statements. (These standards, however, do not affect how a pension fund is actuallyfinanced.) These financial statements may affect the interest rate that the employer pays when ithas to issue debt to, for example, construct or improve its infrastructure, such as schools, in thecase of a school employer, as well as the perceived impact of pensions on their finances.

One component of that disclosure is how the liability is calculated if projected assets areinsufficient to pay projected liabilities. For those liabilities in which projected assets aresufficient, the liabilities are determined based on the assumed investment return, or 7.5 percent inthe case of the DB Program. If the assets are insufficient to pay all liabilities, then the liabilitiesfor which there are no projected assets are calculated based on the 20-year general obligationmunicipal bond index rate, which is currently about 3.5 percent. This will significantly increasethe liability of employers on their financial statements, which could affect other aspects of theirfinancial program.

The new standards first apply to financial statements issued for the 201415 fiscal year. Theliabilities disclosed in that initial statement will be based on the valuation of assets and liabilitiesas of June 30, 2014. If legislation is enacted in this legislative session that materially affects thefunding of the DB Program, even if the enacted changes arent implemented until a future year,the June 30, 2014, valuation will reflect those projected additional resources available to fund theprogram liabilities. Depending on the magnitude of those increases, the liabilities reflected inthose initial statements would, to at least a greater extent, be calculated based on the assumedinvestment return rather than the municipal bond rate, significantly reducing the employers

75%


18/26

16 of 24

liabilities on their financial statements, and increasing their ability to issue bonds for other partsof their programs. In order to fully avoid reflecting a lower discount rate in projecting liabilities,however, that legislation must increase contributions in the future that avoid a projected point inwhich program assets are entirely depleted, in accordance with GASB standards. Consequently,achieving this objective would necessarily preclude funding approaches that only marginally

increase contribution rates. If the legislation is enacted in 2015 or later, however, the initialfinancial statements will reflect a larger liability based on the municipal bond rate.

The figures above project the impact of changing either an alternative objective, an alternativetime period, an alternative starting point or an alternative rate of contribution increases. Theexhibits below illustrate the implications of varying more than one of these considerations. Thefirst set of examples illustrate the impact of fully funding the DB Program over either 30 or 75years, beginning in either 2014-15 or 2016-17, and with contributions increasing at the rate ofeither three percentage points per year or 1.5 percentage points per year. The second set ofexamples illustrates the impact of targeting an 80 percent funded ratio, with the same variationsin the different issues. The examples also illustrate how the ratio of program assets to program

liabilities is projected to change over time under each specific example.

75%


19/26

Contribution Increases

or Specic Targets

ll scenarios based on the June 30, 2011,

ctuarial Valuation, adjusted per Chapter

96, Statutes of 2012, and 2011-12

nvestment return.

nce full funding is reached, the increased

ontribution rates can be eliminated.

0%

50%

100%

17.2%

Resulting funded ratio

Note that in each scenario,

the funded ratio is expected to

decline before increasing to the

target funded ratio.

Contribution rate increase, as a percent of payroll

The total additional contribution needed to meet the

target funded ratio over the specied timeframe. Con-

tribution rate will be slightly higher if allocated among

members and the state.

Scenario Target Funding Timeframe Annual Rate Increase Start Date

Example 100% 30 years 3% 201415

In 30 years

funding ratio will

be at or above

In 75 years

funding ratio will

be at or above


1 100% 30 years 3% 201415

0%

50%

100%

17.2%

100%

100%


3 100% 75 years 3% 201617

0%

50%

100%

11.1%100%

60%

100%

100%

Scenario Target Funding Timeframe Annual Rate Increase Start D

4 100% 75 years 1.5% 2014

0%

50%

100%

11.0%100%

60%

Scenario Target Funding Timeframe Annual Rate Increase Start D

2 100% 75 years 3% 2014

0%

50%

100%10.2%

100%

62%

10.2%

RI75%


20/26

Scenario Target Funding Timeframe Annual Rate Increase Start Dat

6 80% 30 years 3% 201617

0%

50%

100%

14.7%

100%

80%

Scenario Target Funding Timeframe Annual Rate Increase Start Date8 80% 75 years 1.5% 201617

0%

50%

100%

11.3%80%

55%


7 80% 75 years 3% 201415

0%

50%

100%

9.6%80%

59%


5 80% 30 years 3% 201415

0%

50%

100%

13.4%100%

80%

Contribution Increases

or Specic Targets

ll scenarios based on the June 30, 2011,

ctuarial Valuation, adjusted per Chapter

96, Statutes of 2012, and 2011-12

nvestment return.

nce full funding is reached, the increased

ontribution rates can be eliminated.

0%

50%

100%

17.2%

Resulting funded ratio

Note that in each scenario,

the funded ratio is expected to

decline before increasing to the

target funded ratio.

Contribution rate increase, as a percent of payroll

The total additional contribution needed to meet the

target funded ratio over the specied timeframe. Con-

tribution rate will be slightly higher if allocated among

members and the state.


Example 100% 30 years 3% 201415

In 30 years

funding ratio will

be at or above

In 75 years

funding ratio will

be at or above

100%

100%

RI75%


21/26

19 of 24

The four scenarios that illustrate contribution rate increases to achieve an 80 percent funded ratiodemonstrate the impact of earlier rate increases compared to rapid accelerations of contributionrates. The difference between Scenario 5 and Scenario 6 is that the contribution rates in Scenario5 begin in 2014-15, while the increases in Scenario 6 begin in 2016-17. Because of that two year

delay, the projected total required increase in contribution rates is 1.3 percentage points more inScenario 6. On the other hand, the difference between Scenario 7 and Scenario 8 is that inScenario 7, contribution rates increase by three percentage points per year, compared to the 1.5percentage point annual increase in Scenario 8. Because contribution rates increase more rapidlyunder Scenario 7, the projected total increase in contribution rates required in Scenario 7 is 1.6percentage points less than is required in Scenario 8. In addition, as a comparison of theprojections in Scenario 3 and Scenario 4 indicate, a more rapid annual increase in contributionrates (as assumed in Scenario 3) can offset the effect of a delayed implementation.

5. Decide How Contribution Rate Increases Get AllocatedOnce the total amount by which contribution rates need to be increased is determined, theLegislature must determine how to allocate those increases among members), employers and thestate. Although there are no contractual impediments to increasing the contribution rates paid byfuture members, employers and the state, the ability to increase the contributions paid by currentmembers is limited by the contractual nature of that contribution rate. Under California law,benefits earned by DB Program members, including benefits earned from future service by thosemembers, cannot be reduced, and contributions paid by CalSTRS members cannot be increasedonce they are hired to perform service subject to coverage in the DB Program, unless themembers receive a corresponding, offsetting advantage. The only means by which thecontribution rate can be increased is to provide the member with an increased benefit ofcomparable value. Generally, the cost of the increased benefit would offset any revenueassociated with the increased contribution, negating any value of the higher contribution inaddressing the funding shortfall.

One instance in which the contribution paid by current members could be increased withoutrequiring an offsetting increase in liabilities is the annual 2 percent benefit adjustment. Thisbenefit is not contractually guaranteed because the Legislature explicitly reserved the right toreduce or eliminate the 2 percent annual benefit adjustment. As a result, the Legislature couldreduce liabilities for existing members by making changes to the adjustment. However, becausethe statute requires the adjustment be paid, subject to the enactment of future legislation tomodify it, the actuarial valuation of the DB Program reflects the cost of providing theadjustment. If legislation was enacted that eliminated that explicit legislative reservation, suchthat the 2 percent benefit adjustment was guaranteed in the same manner as the other DBProgram benefits, there may be a legal basis to increase the contributions paid by currentmembers because they would receive a comparable advantage from the benefit now beingguaranteed. Nonetheless, because the cost of providing the benefit adjustment is already reflectedin the financing of the DB Program, there would be no additional cost to the program. Basedupon legal analysis by outside counsel a guarantee of the 2 percent improvement factor wouldlikely be determined to be a comparable advantage compared to a similar increase incontributions. (This analysis was based on a prior investment return assumption of 7.75 percent

75%


22/26

20 of 24

annually; given the current assumption of 7.5 percent, the maximum increase in contributions isnow slightly higher.)

In addition, although there is no legal impediment to an increase in employer contributions, suchincreases could ultimately require the state to provide more funding to K-12 and community

college education under Proposition 98. Both the Legislative Counsel and the Attorney Generalwere asked in 2006 whether an increase in the statutorily-required employer contribution to theDB Program would result in an increase in the states obligation to schools under Proposition 98.The Attorney General concluded it did not, but the Legislative Counsel opined that if theincreased contribution was to fund the benefit program in effect in 198687, the statesobligation under Proposition 98 would increase to offset that amount. Some stakeholder groupsmight believe the states obligations would increase under any circumstances of an increasedemployer contribution. Resolution of that legal issue should be attempted in order for theLegislature and the Governor to understand the true impacts of changes in contribution rateincreases.

A specific increase in the contribution rate will have a slightly greater impact if paid by theemployer rather than the member or the state. This is because for members who terminate theiremployment and refund their contributions, those contributions are not available to fund benefitsin the DB Program. In contrast, the employers contribution for that member remains in theprogram, and is available to fund benefits paid to the remaining members of the DB Program.Inaddition, the contribution paid by the state is based on the compensation paid to members twoyears before the contribution is paid by the state, whereas the employer contribution is made onthe current payroll. To the extent that total compensation increases annually, therefore, theamount of money contributed by the state from a specific increase in the rate will be less than theamount paid by an employer for that same percentage increase in the contribution rate. Thedifference in the dollar amount contributed by the state from the same percentage increase in therate paid by the employer, however, is currently 6.6 percent, while the difference in the net dollaramount contributed by members from the same percentage increase in the rate paid by theemployer is about 3 percent.

The examples below provide examples of how contributions increased under two of thescenarios illustrated earlier (Scenario 4 and Scenario 8) could be allocated among current andfuture members, employers and the state, in a manner that reflects the legal constrictionsimposed on member contributions. Although the approach ultimately adopted in legislation toaddress the funding shortfall will likely differ from any of these examples, these examplesillustrate the implications of these approaches on individual stakeholders.

75%


23/26

Annual rate

of increase

Total additional

contribution

Existing

contribution rate

Total

contribution rate

Members 0.5% 2.6% 8% 10.6%

EmployersInitially 0.5%, increasing to 1% in 2016-17,

increasing to 1.5% in 2019-207.48% 8.25% 15.73%

State 0.5 1.085%3.522% and

2.5% for SBMA7.107%

Scenario Target Funding Timeframe Start Date

4 100% 75 years 201415

11.2%

AdditionalIncrease

Annual rateof increase

Total additionalcontribution

Existingcontribution rate

Totalcontribution rate

Members 0.5% 2.6% 8% 10.6%

Employers0.5%, increasing to 1% in 2018-19,

increasing to 1.5% in 2021-227.86% 8.25% 16.11%

State 0.5 1.085%3.522% and

2.5% for SBMA7.107%

Scenario Target Funding Timeframe Start Date

8 80% 75 years 201617

0%

5%

10%

15%

20%

25%

30%

35%

40%

11.5%

Additional

Increase

0%

5%

10%

15%

20%

25%

30%

35%

40%

RI75%


24/26

22 of 24

These examples illustrate that, depending on how much of the increased contribution is allocatedto members and the state, the total increase in required contributions will be higher than theincreases indicated for those scenarios on page 21 because, as discussed earlier, a one percentagepoint increase in the member or the state contribution rate generates less in contributions than a

one percentage point increase in the employer contributions rate. In addition, it is likely that theemployer rate will increase by more percentage points per year in later years as member or statecontribution rates reach whatever maximum contribution rate is enacted in the legislation thatincreases contribution rates. Finally, because of the two-year delay in implementing the increaseunder Scenario 8, a larger total contribution rate is required in Scenario 8, even though it resultsin a lower funded ratio than Scenario 4.

6. Establish a Date to Re-evaluate DB Program FundingThe outcomes shown above assume that CalSTRS meets all the economic and demographicassumptions underlying the actuarial valuation of the DB Program, in particular, that CalSTRS

earns 7.5 percent annually from investing program assets. It is expected that in any one year, therate of return on the portfolio will either be higher or lower than the assumed rate. As a result,over the long-term, such as 75 years, there is a high probability that implementation of any ofthese scenarios will either result in (1) too little funding being provided to prevent the completedepletion of program assets, although at a later date than the currently projected 2046, or (2) toomuch funding, resulting in the accumulation of program assets over 75 years that exceed 110percent of program liabilities. In fact, in any of these scenarios, or in any other scenario in whichCalSTRS undertook a preliminary analysis, the probability of too little or too much fundingbeing provided during the next 75 years exceeded 85 percent, although different scenariosresulted in different probabilities of too little funding being generated. To the extent that thedesired outcome is a substantially greater level of funding, there is a higher probability thatassets could ultimately significantly exceed liabilities; conversely, if the desired outcome is moremodest, there is a greater probability that assets will be insufficient to pay future liabilities.

One means of illustrating this sensitivity is by comparing projected funded ratios over time basedon different investment assumptions. The graphic below shows how the projected funded ratiounder Scenario one would change if contributions rates were increased by the amount needed tofully fund the DB Program in 30 years beginning in 2014, based on a 7.5 percent investmentreturn. It compares those funded ratios to the projected ratios over time that would be achieved ifinvestment returns were seven percent or eight percent annually.

75%


25/26

23 of 24

This uncertainty of investment returns, and its impact on the ultimate success of a fundingprogram, indicates that the Legislature, in enacting a funding program during the 2013-14

Regular Session as intended by SCR 105, should expect to re-evaluate the need for additional

changes in program funding sometime in the next ten to 15 years, either to address a situation in

which investments continue to generate returns below expectations, in which case furtherincreases in contribution rates would be required, or investment returns exceed expectations, in

which case some of the enacted increases in contributions could be reversed. This reevaluationcould be in the form of direction that either (1) the Governor sponsor legislation at a specific

future date that modifies future contribution rates to maintain an appropriate level of long-term

funding or (2) the 2013-14 legislation enact specific future adjustments to the contribution rateprogram in response to specified funding conditions at a future date.

CONCLUSIONS

The weak financial markets of the past decade, together with the fact that contribution rates werenot adjusted in response to the low returns, have undermined the long-term funding of the

Defined Benefit Program, which can only be effectively addressed by increasing thecontributions paid by a combination of members, employers and the state. Implementation of

that funding program requires the enactment of legislation by the Legislature that is approved by

the Governor. Although such a program will have a significant impact on those stakeholdersresponsible for paying the higher contributions, those impacts can be mitigated by increasing

those contributions in a gradual manner that is sensitive to the budgetary needs of the

75%


26/26

stakeholders. This report identifies the decisions the Legislature and Governor must consider inorder to address the long term funding shortfall in the CalSTRS DB Program.

Although increases in contributions can be deferred and gradually implemented, the sooner theseincreases become effective, the less costly it ultimately will be to those who pay the higher

contributions, and the less impact that a pension funding shortfall will have on school employerabilities to implement their own financial program. In addition, it is extremely likely that anyfixed contribution program in the long run will result in excessive or inadequate resources tofund the benefits, if the funding program is never adjusted. Consequently, the Legislature willneed to establish a mechanism in the funding legislation that facilitates the adjustments needed tomaintain an appropriately funded benefit program.

CalSTRS stands ready to assist the Legislature and the Governor as requested to help them enacta solution to provide long-term viability in this important component of a public educatorsretirement security.

Documents

CalSTRS Pension Shortfall